It Starts: San Francisco Office Boom Deflates, but Fitch Says It’s “Unlikely to Collapse” this Time

Other tech-heavy office markets too.

For some time, we’ve heard through the rumor mill that commercial real estate brokers in San Francisco are getting nervous. Then Savillis Studley released its report on the San Francisco office market for the fourth quarter. A very mixed bag for the first time since 2009. And now even Fitch Ratings is getting antsy.

A prominent sublet space to hit the market is an entire floor at Twitter’s headquarters. Twitter has been laying off, and it won’t need this space. This comes after Twitter abandoned plans to lease an additional 100,000 square feet at the nearby headquarters of Square, the other company where Twitter CEO Jack Dorsey is the CEO. Those 100,000 sf then came on the market as well.

As new office space came on the market, absorption has been negative for two quarters in a row, reaching -500,000 sf during Q4. With supply and vacancies up, even as prices soared, something had to give: demand collapsed. Tenants leased 5.9 million square feet in 2015, down 35.7% year-over-year.

San Francisco cloud-storage startup Dropbox is emblematic of what is going on in tech-based local economies, including commercial real estate (CRE), which has been in a phenomenal boom in terms of lease rates and construction, powered by a global money tsunami.

Dropbox does what Google, Apple, Amazon, IBM, Microsoft, and other companies with cloud-storage services are doing. So this is going to be tough. Nevertheless, it has a “valuation” of $10 billion, as of its last round of funding in January 2014. It’s one of the deca-unicorns. Or perhaps, “was” because, to let some folks cash out, it has authorized the sale of common stock on the “secondary market” at a 34% discount, BuzzFeed reported. While some discounting is not unusual in these situations, it is a big cut, reminiscent of the “valuations” cuts of other startups since last summer. Not a propitious sign.

With these sorts of valuation cuts ricocheting through tech land, Fitch Ratings warns in its manner: “Tech-oriented U.S. commercial real estate market fundamentals have cooled but are unlikely to collapse.” And then it lays out just how likely these fundamental are to collapse.

The risks: “lower tech-tenant demand in markets such as San Francisco, Silicon Valley, Seattle, New York and Los Angeles,” “cooling tech employment,” and “capital availability.”

This “capital availability” is crucial. But the IPO window shut late last year and big corporate buyers have largely lost their appetite for gobbling up startups at multi-billion-dollar valuations. As the exit doors for investors are closing, they have trouble converting “valuations” into real money. And so the new money, seeing this happening, is drying up.

Fitch points at the bane of office markets: “speculative leasing.” It turns a growth market into a dizzying boom, and it turns the next downturn into a rout.

The amount of speculative leasing is a key unknown that will influence the severity of office market downturns due to lower tech tenant demand. Speculative leasing occurs when companies lease more space than then they currently need in anticipation of future growth, typically motivated by concerns over rapidly rising rental rates and limited space availability.

Speculative leasing was “a key reason for the collapse in office rents in San Francisco and Silicon Valley following the tech bubble burst in the early 2000s,” Fitch reminded us.

At the time, market participants generally expected the San Francisco market to weather a tech industry downturn reasonably well, since new supply was balanced with demand growth. In hindsight, investors underappreciated the artificial demand boost from rampant speculative leasing by weak credit tenants.

And now speculative leasing is back in all its glory. See Twitter’s headquarters, which is far bigger than what Twitter now needs or wants. Or Square’s headquarters. Or the big ones….

Among the massive amounts of new office space coming on the market this year and next is the 61-story Salesforce Tower. Salesforce leased 714,000 sf in it. That’s a lot more than the 423,000 sf it currently occupies.

Salesforce sold its old site to Uber and its development partner. Once Salesforce has moved out, Uber will move into these 423,000 sf, which is a lot more than what it has now.

LinkedIn is also moving into its new space of 452,000 sf, in two phases, starting this month and to be completed by 2017.

Companies like these have made plans to hire lots of people and fill the huge vacant spaces that they leased or bought. If those plans don’t pan out – see Twitter – this office space becomes “speculative space” and ends up on the market. This type of office-space hoarding has been a big force on the way up.

With space seemingly in short supply and lease rates soaring, panicked companies awash with money, even startups with no revenues, have hoarded office space to grow into, thus injecting steroids into the office boom.

If they don’t need it, they can always put it on the market and sublease it. That’s the logic. But if push comes to shove, they will all put it on the market at the same time, just when practically no one needs more space.

There is an additional problem with startups: when the moolah dries up, many will burn through their cash before they figure out how to get a positive cash flow and sustain themselves. When these companies reach the end of their road, landlords end up with empty office space, and that too is going to hit the market.

These forces happen simultaneously. The office market turns into a glut. It puts enormous downward pressure on lease rates – and everything that comes along with them. Real estate is highly leveraged. When it gets ugly, a chain reaction mauls banks, creditors, and investors of REITs or commercial mortgage backed securities (CMBS). That’s what Fitch is warning about.

As miracles are deflating, a brutal process has set in. And debris from the collapse is hitting investors left and right. Read… It Gets Ugly in the Startup Bust

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Perhaps the Chinese can be persuaded to buy some more of the SF office space that’s coming to market.. And to them, keeping real estate empty for years is common practice and so not a problem. Their mindset is just fundamentally different from our western preconceptions: Many Chinese real estate investors actually desire that their investments stay unused, so that it retains its ‘mint’ condition.

Ironically, the Chinese are heavily involved on the other side of the equation, the building boom, including a project with two towers and some other buildings, one of which will be the second highest tower in the city, after the Salesforce Tower.

Chicken

Mar 22, 2016 at 11:30 am

I’m thinking they (Chinese) are doing this due to they get some kind of US government tax incentive.

Thus they’ll probably make money while growth is pulled forward and dumped on the US taxpayer just like Spain, Italy, etc., at any cost?

Someone had mentioned a FED head was walking his dog in Boston one morning, looked up and counted too many construction cranes and voted to raise rates.

Ptb

Mar 22, 2016 at 9:02 am

I spent more than 20 years in tech start ups, mostly software. It’s very common for them to drastically over supply themselves for their future “growth”…especially after they’ve gotten a little traction in the market. Growing organically is only for the non-funded companies.

NotSoSure

Mar 22, 2016 at 9:42 am

A friend just got hired and relocated from overseas at Twitter as a senior engineer and they are building a couple of new teams stuffed with engineers. Not sure why they couldn’t just reassign those that had been let go.

Also went to the HQ last week. Very nice cafetarias.

TheDona

Mar 22, 2016 at 9:53 am

Cuz they are cheaper.

NotSoSure

Mar 22, 2016 at 12:08 pm

Nope. Sorry to break the illusion. My friend from overseas got a 200K+ salary as a principal engineer. Let’s not count the stock knowing what they are worth right now.

TheDona

Mar 22, 2016 at 2:47 pm

They are probably changing over to another new software platform. Keep us posted on your friend in a year or two.

Toddy

Mar 24, 2016 at 6:43 pm

Probably has a very hard to find specialty skill. Some specialty engineers straight out of school can command starting salaries of over $300k plus signing bonus.

But in tech, you usually are obsolete after a short while as a specialist and then you go back to working at an average salary.

Then you see them working through lunch and if you have properly monetized that productivity, the free streak is a genuinely high margin investment.

OutLookingIn

Mar 22, 2016 at 11:09 am

The western Canadian oil province of Alberta has been suffering the same higher commercial vacancy rate increase as western US.

The flood of empty lease/rental space began with the down turn of the oil price early last year. The vacancy rate increase has steadily climbed and has not topped out yet. In Calgary there are now noticeably “see through” office towers dotting the skyline.

The knock-on-effect is just now starting to bite deeply into the local economy. Tax receipts have fallen. Food bank usage is up. Low cost housing is non-existent, while residential vacancy rates rise. City services have become inundated with requests for help. Private NGO’s have reported heavy traffic for services. Homelessness has spiked up with city shelters being overrun by those seeking respite. City police report a spike in domestic violence and substance abuse.

This is what San Francisco has to look forward to, as has every other city in North America. The so-called recovery occurred on Wall street, but the grassroots/Main streets have seen nothing but a slow grind down, that is continuing and will become worse before any light shows through.

OutLookingIn

Mar 22, 2016 at 2:14 pm

As a footnote to above:

Alberta Terra Energy Corp. has announced it has ceased production and has shut down production, when the Canadian Western Bank demanded full debt payment. The directors and officers of the company announced their resignations as of yesterday.
Along with employees losing their jobs, the companies share holders will be left with nothing but future bankruptcy proceedings, which could take years to unfold.

walter map

Mar 22, 2016 at 7:25 pm

“This is what San Francisco has to look forward to, as has every other city in North America.”

As the U.S. economy is liquidated in favor of cheap-labor tax havens, you can expect the country to increasingly resemble Haiti. Rust-Belt cities and certain expanses of the southern Sahara of the Bozart are way ahead of the curve, of course.

Chicken

Mar 22, 2016 at 11:22 am

Just when it looked like Square would make a ton of money and turn things around by renting to Twitter! Each should rent to the other, surely there’s synergy there between them via the tax break.

Chicken

Mar 22, 2016 at 11:37 am

Oh, and hopefully someone gets the bright idea to migrate the construction boom into Cuba, US taxpayer would love to hire contractors and reconstruct Havana and provide free modern office space at a loss b/c US taxpayer has a huge heart and contractors have needs.

A rolling stone gathers no moss, but it does leave a giant wake of toxic balance sheets.

Michael

Mar 22, 2016 at 12:49 pm

This nonsense is like watching monkeys playing with a box full of hand grenades.

Lee

Mar 22, 2016 at 2:16 pm

For those interested in the Australian market, the latest information I could find shows a 7.7% vacancy rate for Melbourne offices. Sydney is at 6.3%.

Residential vacancy rates vary quite a bit by area with an overall residential vacancy rate of 3.1% for Melbourne which reflects the huge number of apartments in the CBD.

Out in the sticks the Victorian vacancy rate is 2.1% and where I live the vacancy rate is a whopping 1.3%……….

The funny thing about all this ‘hoarding’ is that the mantra of tech is the opposite- you don’t have to be physically present to write, test or modify software, or to skype or video conference.
The whole point of the internet is to enable distant access.

As important as the social media bubble is to SF- it is the core of the apple- for the rest I suspect the usual suspect- the somewhat bizarre tendency of people to make huge sacrifices in their actual life style for a perceived feeling of being at the center of the action. So we have incredible densities where the only attraction is…density.

Each to their own of course- but personally I find it a huge imposition to get into an elevator each time I wanted to leave or arrive.

Petunia

Mar 23, 2016 at 10:14 am

SF will deflate like other areas have when the average working person is priced out of the market. We left New York City many years ago, driven out by the crime and taxes, and never looked back. We have now been priced out of South Florida. We moved last month and already we don’t miss it.

I have just seen a headline that says a $250K income qualifies you for subsidized housing in SF. I think this is the beginning of the end for the tech bubble. When you are better off working a crappy job in a crappy place over working a tech job in SF or NYC that signals the end.

HB Guy

Mar 23, 2016 at 3:36 pm

I don’t dispute that SF and Hongcouver are destined for a significant correction. I do question whether or not the LA-Orange County areas will also have one.

There are several local conditions, in particular, new single family and condo construction, and in coastal areas, lack of new or existing rentals, that are likely to support current market prices. The vacancy rate in LA, and especially the OC, are especially low. This is likely to be true even if/when Chinese flight capital ceases to flow into Irvine, the San Gabriel Valley, etc.

Other So CA markets like the Inland Empire and San Diego have better supply and lower prices, and could be more impacted by price fluctuations.